What investors should know before they dive in.
Once reserved for the very wealthy and ultra-patient, illiquid investments such as rare earth metals, defaulted and distressed bonds, and nontraded REITs are increasingly being packaged in liquid wrappers. This movement's latest incarnation is sponsored by the private equity community. Private equity firms including Carlyle Group
In exchange for locking up your money for seven to 10 years, traditional private equity funds expect to offer a higher rate of return than the listed stock market (this extra return is called a liquidity premium), with a relatively low correlation (as the private and concentrated nature of the investments prevent them from moving closely with the listed markets). Private equity funds largely have met their goal: Cambridge Associates U.S. Private Equity Index, for example, returned twice as much as the S&P 500 between April 1997 and September 2012 (13.6% net of fees versus 6.1%, respectively), with only a 0.78 correlation (using quarterly returns).
Unfortunately, private equity is largely out of the reach of retail investors, who typically do not meet accredited investor rules, and who typically do not have several million to invest. In 2007, Red Rocks Capital attempted to democratize private equity by launching a listed private equity mutual fund ALPS/Red Rocks Listed Private Equity
While it's too soon to tell how these investments will fare, some appear better positioned for success than others. Investment vehicles that promise liquidity but whose underlying investments are largely illiquid have a high likelihood of backfiring. Vehicles that promise liquidity and can actually deliver it may be good investments, but their risk/return profile may not match private equity's. Here is a deeper dive into some of these newer products, and the pros and cons for each.
CPG Carlyle Private Equity Fund
In November 2012, Central Park Advisers filed an application for the CPG Carlyle Private Equity Fund LLC. This is a 1940 Act-registered, nontraded, closed-end, interval fund that will invest primarily in other new and existing private equity funds (direct private equity investments are allocated only 0% to 20% of the fund's total assets). The benefit of the fund, according to the filing, is to have "preferred access to investment fund managers affiliated with Carlyle." The fund will be managed by Mitchell Tanzman and Gregory Brousseau of Central Park Group, which is a fund of funds firm the managers founded in 2006.
This fund's closed-end interval structure, while still requiring "accredited investor" status, is accessible for only $50,000 and files quarterly disclosures on its performance and holdings, unlike typical private funds. The fund also anticipates that it will offer quarterly redemptions of up to 5% of the assets of the fund. In order to create this liquidity, the fund has to be creative. It will hold some liquid assets, potentially use leverage (within the limitations specified by the 1940 Act), and invest in secondary offerings of private equity fund shares (which may have shorter holding periods). Finally, the fund will manage liquidity through its "commitment strategy." Essentially, this fund will hold cash that has been committed to underlying private equity funds, but which has not yet been deployed.
While this fund presumably will give investors true private equity exposure, with more liquidity than traditional private equity funds, there are some major risks associated with this type of structure. First, the fees: There are management and incentive fees of 1.00%-1.75% and 20% respectively; a second-layer management fee of 1.20% (with a cap of 0.75% for the first year); operational and offering expenses of the fund of funds and the underlying funds; a sales load of up to 3.50%; and a redemption fee of 2.00% for the first year. Added up, these expenses will take a big bite out of the fund's returns.
Second, there's no guarantee that the fund will deliver on its 5% anticipated quarterly tenders. Investors in Salient's Endowment Registered Fund, a similar closed-end interval fund, learned this the hard way in January 2013, when the fund suddenly stopped redeeming shares. CPG Carlyle Private Equity's application suggests it will use its already committed capital to fund tender offers. It may also "overcommit" its capital to the underlying funds to boost returns, a strategy which could dry up cash intended to fund redemptions.
Apollo and KKR
Apollo Credit Management, a recently formed registered investment advisor, launched two traded closed-end funds, Apollo Senior Floating Rate Common AFT and Apollo Tactical Income Common
It appears that Apollo's products provide a better match between the liquidity of the underlying investment and the liquidity of the investment vehicle than the CPG Carlyle product. Investors in Apollo's listed CEFs can create their own liquidity by buying and selling shares on the open market, rather than forcing the portfolio managers to buy and sell illiquid credits as a result of inflows and outflows. Listed CEFs have additional costs related to trading, though--namely, bid-ask spreads, which can be wider for more thinly traded CEFs, and premiums or discounts to net asset value. Also when investing in CEFs, investors must keep in mind that the management fees can be higher than stated, due to leverage.
Unlike Apollo's closed-end funds, KKR's CEF is not traded at all and hopes to offer quarterly liquidity on illiquid credit investments, similar to CPG Carlyle's closed-end interval fund. Investors worried about this potential liquidity mismatch could turn to KKR's open-end mutual fund, which is restricted to 15% illiquid investments by 1940 Act rules. Investors should keep in mind, though, that KKR's mutual fund is more expensive than the typical high-yield bond fund (1.20% prospectus net expense ratio, versus 0.75% for the median institutional share class high-yield bond fund).
Blackstone Alternative Investments Funds
In March 2013, Blackstone Alternative Asset Management, a subsidiary of private equity firm and hedge fund manager Blackstone Group, filed an application for a mutual fund. It appears that this firm's offering will steer entirely away from private equity, however, and focus on more-liquid hedge fund strategies. The fund appears to be a multimanager, multistrategy fund, using both affiliated and unaffiliated subadvisors (which can include UCITS funds and hedge funds listed on foreign exchanges). The potential strategies include fundamental, global macro, opportunistic trading, quantitative, managed futures, and multistrategy. These strategies appear to be a good fit for a liquid mutual fund, which by regulation can only invest up to 15% of its assets in illiquid securities. Investors should look out for fees, however, as multimanager funds are typically more expensive than single-manager offerings.
ALPS/Red Rocks Listed Private Equity
Red Rocks, a lesser-known asset manager, has a longer track record of combining private equity and public mutual funds. The firm was founded in 2003 by Adam Goldman and Mark Sunderhuse. Goldman's experience is in private equity, particularly in venture capital, while Sunderhuse's expertise is in small-cap growth equity. In late 2007, the duo launched the first open-end mutual fund attempting to capture private equity exposure.
The firm cleverly defines and gains access to private equity. The fund invests in the global publicly traded stocks of the private equity managers, such as Carlyle, Apollo, KKR, and Blackstone, as well as stocks that invest in other companies in a private equity fashion (Ackermans & van Haaren NV
The Red Rocks fund offers perhaps the most sensible way for retail investors to gain access to private equity while maintaining liquidity. It's not clear that investors are getting similar returns or risk exposures as they would in private equity, however. The Red Rocks Global Listed Private Equity Index (which dates back to 1997) exhibits a 74% correlation to the Cambridge Associates U.S. Private Equity Index (there is no good global private equity index), which is high, but it could be higher. And between April 1997 and September 2012, the listed private equity index experienced lower returns (11.18% versus 13.60%) with a much higher standard deviation (30.3% versus 12.1%, using quarterly data). Notably, the listed private equity index did provide a slightly better risk-adjusted return over this period than the S&P 500.
In summary, investors have a growing number of ways to diversify their portfolios with private investments. It's important to be well-versed in how these investments attempt to provide liquidity, and to be mindful that there are always trade-offs.